Review of Quantitative Finance and Accounting, 16: 191–203, 2001
2001 Kluwer Academic Publishers. Manufactured in The Netherlands.
Linear Accounting Valuation When Abnormal
Earnings Are AR(2)
JEFFREY L. CALLEN
Rotman School of Management, University of Toronto, 105 St. George Street, Toronto, Ontario M5S 3E6, Canada,
Tel: (416) 946-5641
School of Business Administration, The Hebrew University, Mount Scopus, Jerusalem, Israel 91905,
Abstract. The Ohlson (1995) model assumes that abnormal earnings follow an AR(1) process primarily for
reasons of mathematical tractability. However, the empirical literature on the Garman and Ohlson (1980) model
ﬁnds that the data support an AR(2) lag structure for earnings, book values and dividends. Moreover, the AR(2)
process encompasses a far richer variety of time series patterns than does the AR(1) process and includes the
AR(1) process as a special case. This paper solves the Ohlson model directly for an AR(2) abnormal earnings
dynamic. The model is estimated on a time series ﬁrm-level basis following the approach used by Myers (1999). It
is found that, like the Ohlson AR(1) model, the Ohlson AR(2) model severely underestimates market prices even
relative to book values. These results further bring into question the empirical validity of the Ohlson model.
Key words: linear accounting valuation models, Ohlson model
JEL Classiﬁcation: M41, G12
Ohlson’s (1995) valuation model (hereinafter the Ohlson model) is important to accounting
research not only because it relates security prices to accounting numbers in a rigorous
fashion but also because it has become widely adopted by accounting empiricists.
appear to be three principal reasons as to why accounting empiricists have embraced the
model as wholeheartedly as they have. First, the few alternative models suggested by the
accounting literature are either ad hoc, not having been developed from underlying prim-
itives, or they are difﬁcult to implement empirically.
Second, on a more positive note,
Ohlson’s model, by focusing on the Clean Surplus relationship, shifts the overemphasis on
the income statement by the earlier accounting literature, and brings the balance sheet back
Correspondence address: Dr. Mindy Callen-Morel, School of Business Administration, The Hebrew University,
Mount Scopus, Jerusalem, Israel 91905. Tel: (02)5883110. E-mail: email@example.com